Slippery slope to job creation
By Hossein Askari and Noureddine Krichene
Over the past decade, the profligacy of the US Federal Reserve has ended with
financial chaos in the United States and in Europe, with low growth and high
unemployment as the longer-term legacy.
Fed chairman Ben Bernanke, a Keynesian, vowed in 2002 to fight deflation and to
stimulate employment. Accordingly, the federal funds rate was set at 1% during
2003-2004; domestic credit in the US expanded at 12% per year; the US dollar
tumbled; and US external deficits deteriorated to 6-7% of GDP.
The Fed was on a mission to secure full-employment no matter
what the collateral damage. It was as if monetary policy had no effect on any
variable or sector except on employment. Fed policymakers were in denial of a
relationship between low interest rates and stratospheric housing prices,
between low interest rates and the fall of the US dollar, or between low
interest rates and external deficits.
Unfortunately, contrary to the prediction of Keynesian model of
full-employment, the US economy fell into financial chaos, bankruptcies,
millions of foreclosures, unprecedented fiscal deficits, and above all,
mass-unemployment. Contrary to the Fedís narrow view that denies any effect of
loose monetary policy except on employment, Fed monetary policy has devastated
many sectors and many countries, and has fueled mass-unemployment.
In 2002, when Bernanke was appointed to the Fed's board of governors under the
chairmanship of Alan Greenspan, he did not anticipate the financial and
economic crises that broke out in August 2007. He appeared oblivious to the
fact that such lax monetary policy would send oil prices racing from $18/barrel
in 2002 to $147/barrel in 2008, housing prices doubling and tripling causing
millions of foreclosures, and food prices flying to sky high levels and pushing
millions into living on food stamps.
As a declared Keynesian, it would appear that Bernanke, who took over as Fed
chairman in 2006, was not much interested in the long-term consequences of Fed
policies, only short-term gains in employment seemed to matter irrespective of
the consequences of overly expansionary fiscal and monetary policies on housing
markets, asset markets, energy, food, or exchange rates.
Yet, it has been repeatedly observed during 19th and 20th centuries that cheap
monetary policies invariably ended in a terrible hangover - serious economic
recessions, even depressions, and widespread financial failures.
Little expertise is required to predict the consequences of overly expansionary
monetary policy. Japan in 1992 was not a surprise: easy money policy in late
1980s culminated into a severe financial crisis and protracted stagnation. The
faster is monetary expansion, the faster is credit expansion, and the faster
and more calamitous the financial crisis and the economic recession.
Adam Smith (d 1790) and Jean-Baptiste Say (d 1832), in opposition to rapidly
expansionary monetary policies, long ago established the inherent contradiction
of what became known as Keynesianism. The Fed (ie the US government) wanted to
achieve full-employment by setting interest rates to negative levels and
printing money; this policy was self-defeating and brought financial collapse
and mass unemployment. The Fed had to "TARP" the financial system with through
the mechanism of the Troubled Asset Relief Program, introduced in late 2008 to
buy trillions of toxic assets, and force even more unorthodox monetary policies
in the name of creating jobs.
It has been the government that has caused economic disorders; it is the
government that has tried to salvage the economy through the same policies that
injured the economy in the first place; and it is the government that is now
caught in a circular and increasingly injurious set of policies that sees
inflationism as the only path to prosperity and full-employment. This is at
best a slippery slope.
Bad government policies beget bad results and bad results, in turn, beget even
worse policies. The Fedís low interest rates and expansionary monetary policy
in 2002-2004, although meant to combat deflation and unemployment, caused
commodity price inflation, housing speculation, and general bank failures in
the US and Europe.
The government had to bailout banks at cost of trillion of dollars. Fiscal
deficits exploded to historic levels. The Fed resorted to printing massive
quantities of money to finance these deficits. Bernanke (again ie the
government) had to re-inflate the economy to prevent housing prices from
falling by injecting about $1.5 trillion.
Fed policies protected debtors at the expense of creditors and reduced their
real debt. Interest rates were set at near-zero bound to stimulate the economy.
The Fed had to create billions of dollars in new facilities to lend to subprime
borrowers. Recently, realizing that core inflation was low, and therefore
inconsistent with the Fedís mandate, chairman Bernanke decided to re-inflate
again by injecting an additional $600 billion. This new money will permit the
financing of larger fiscal deficits.
There is always a political pressure to escalate inflationism to finance fiscal
deficits, protect debtors, and achieve full-employment. Keynesianism and
inflationism have been likened to a drug addiction: one dose calls for stronger
dose to keep the subject in high state, irrespective of the collateral damage
the drug will cause to the addicts's health.
This chain of events started with overly expansionary monetary policies of
2002-2004 and kept on escalating as the financial crisis spread and the
economic downturn intensified. If only the Fed had not followed these
expansionary/inflationary policies in 2002-2004, then no disruption to the
economy, no housing crisis, no bailouts, no mass unemployment, and no commodity
price inflation would have taken place. The economy, in all likelihood, would
have continued on its steady growth path of the two previous decades.
Politicians and supporters have portrayed the Fed as a savior, for salutary
rescue of the financial system, by printing trillions of US dollars in
There is no let-up in the continuation of Fed policies. The Fed's balance sheet
has increased to $2.4 trillion in 2010 from $0.8 trillion in 2008 and could
reach $3 trillion in 2011. Expansionary monetary policy has been propitious for
inflating stock prices and for exacerbating exchange rates instabilities.
US stock price indices rose by between 11% and 13% in 2010 despite economic
stagnation and an unemployment rate of 9.8%. Commodity price inflation has been
raging at accelerating rates. Countries like China and India are grappling with
food inflation in excess of 12% per year. Food prices are escalating in almost
all countries. Oil prices are again about to break again the $100/barrel mark
and should keep on climbing, in turn threatening the fragile recovery; the gold
price, now around $1,440 an ounce, could race upward with no bound.
Certainly, there is no economic coordination among the big powers in spite of
the symbolic existence of the Group of 20. Each country will be guided by its
own domestic agenda. The dollar has been depreciating and tensions are building
among countries. Each will try to peg its currency to the dollar and will
prevent an appreciation of its own currency. Each country will try to inflate
at the same rate as the US or even higher. Such was also the landscape during
the inter-war years.
Previously, the Organization of Petroleum Exporting Countries was blamed for
oil shocks. However, in the past few years, the Fed has been creating its own
oil shocks. The Fed is directly setting oil prices; in fact, its power extends
well beyond oil prices to gold, copper, corn, rice, soybeans, coffee, cotton,
tea, and practically all commodity prices. Even stock prices are directly
jerked up by the Fed, beyond long-term fundamental levels.
With interest rates at near-zero, and billions of dollars injected into
speculative markets, the rise of oil and food prices will have little
resistance. More and more money printing will further distort prices. Many
countries that are oil and food importers will see their growth stalling.
The political forces in the US are strongly supportive of inflationism as a way
to combat the effects of past inflationism and bring the economy to
full-employment and economic growth. This provides the Fed with a free-hand for
inflating. How much can the economy can grow and create employment when
subjected to oil shocks and oil price inflation? Experience has shown that the
economy has invariably stalled under oil shocks; if oil shocks combine with
food shocks then the economy may again suffer as as it did in 2008.
The political myopia that prevailed in 2002 still prevails in 2011. Politicians
try to win electorate support in favor of these policies by promising
full-employment and prosperity, but as Abraham Lincoln said, you cannot fool
people all the time.
Governments are adamantly against nominal adjustment of wages or prices for
clearing markets. Labor unions would oppose any downward adjustment of wages
and salaries. Recently, in a Wall Street Journal article, Peter Schiff showed
that housing prices were too overvalued and needed to drop significantly to
ameliorate the housing sector crisis. In such a political set-up that rejects
market adjustment, the unemployment problem has been simply summed up and
attributed by Keynesians to demand failure.
Only if government dramatically increases spending as called for by former
White House economic advisor Larry Summers, undertakes vast public works
projects, reduces interest rates, and prints money, the whole problem is
solved! Historically, there has not been a country that has been able to bring
down mass unemployment from above 10% to full-employment at 3-4% through simple
inflationism. The stagflation of the US during 1970-1982 illustrated the
dramatic impotence of inflationism to bring the economy back to
The economic prospects for 2011 will be dominated by monetary follies and
fiscal profligacy. Uncertainties should be further heightened. Speculation
could intensify. Exchange rate instability and currency wars may accentuate.
Stock prices will be largely driven by speculative euphoria. Commodity prices
will not stabilize while interest rates are at near-zero and dollar liquidity
is injected without limit; commodity prices will continue to trend upward.
Countries such as China and India may be slowed down by food price inflation.
Hence, 2011 could be as unorthodox as the Fedís unorthodox policies. All the
while, addicts continue to see a strong and lasting recovery just around the
Hossein Askari is Professor of International Business and International
Affairs at the George Washington University. Noureddine Krichene is an
economist with a PhD from UCLA.